Final Foreign Tax Credit Regs

 [4830-01-u]

[2] ACTION: Final regulations.

[3] SUMMARY: This document contains final income tax regulations relating to the computation of foreign taxes deemed paid under section 902. Changes to the applicable law were made by the Tax Reform Act of 1986 and by the Technical and Miscellaneous Revenue Act of 1988 (TAMRA). These regulations provide guidance needed to comply with these changes and affect foreign corporations and their United States corporate shareholders.

[4] DATES: These regulations are effective January 7, 1997.

[5] Applicability: For the specific dates of applicability of these regulations, see sections 1.902-1(g) and 1.902-3(l).

[6] FOR FURTHER INFORMATION CONTACT: Caren S. Shein (202) 622-3850 (not a toll free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

[7] The collection of information contained in these final regulations has been reviewed and approved by the Office of Management and Budget in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under control number 1545-1458. Responses to these collections of information are required by the IRS to implement the section 902 pooling regime enacted in the Tax Reform Act of 1986.

[8] An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number.

[9] The burden for the collection of information is reflected in the burden for Form 1118.

[10] Comments concerning the accuracy of this burden estimate and suggestions for reducing this burden should be sent to the Internal Revenue Service, Attention: IRS Reports Clearance Officer T:FP, Washington, DC 20224, and to the Office of Management and Budget, Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington, DC 20503.

[11] Books or records relating to the collections of information must be retained as long as their contents may become material in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as required by 26 U.S.C. 6103.

BACKGROUND

[12] Section 902 (26 CFR part 1) was amended by section 1202(a) of the Tax Reform Act of 1986 (Public Law 99-514, 100 Stat. 1085), and section 1012(b) of the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) (Public Law 100-647, 102 Stat. 3242). On January 6, 1995, the IRS published a notice of proposed rulemaking in the Federal Register (60 FR 2049 [INTL-933-86 (1995-1 C.B. 959)]). The proposed regulations provide guidance needed to comply with section 902 as amended in 1986 and 1988. No public hearing was requested or held, but numerous written comments were received. The proposed regulations, with certain changes made in response to comments, are adopted in this Treasury decision as final regulations. The principal changes to the regulations, as well as the major comments and suggestions, are discussed below.

EXPLANATION OF PROVISIONS

Section 1.902-1

[13] In the preamble to the proposed regulations, the IRS requested comments on whether the holding of Revenue Ruling 71-141 (1971-1 C.B. 211) should be expanded to allow taxes paid by a foreign corporation to be considered deemed paid by domestic corporations that are partners in domestic limited partnerships or foreign partnerships, shareholders in limited liability companies, beneficiaries of domestic or foreign trusts and estates, or interest holders in other pass-through entities. The revenue ruling held that two 50-percent domestic corporate general partners of a domestic general partnership that owned 40 percent of a foreign corporation were entitled to compute an amount of foreign taxes deemed paid under section 902 with respect to dividends they received from the foreign corporation through the partnership.

[14] The IRS received numerous comments in response to the request in the preamble. The commenters uniformly argue that the aggregate theory of partnerships should apply to allow domestic corporate partners to compute an amount of foreign taxes deemed paid with respect to dividends paid to any partnership by a foreign corporation, provided that the partner owns at least 10 percent of the voting stock of the foreign corporation through the partnership.

[15] The final regulations do not resolve under what circumstances a domestic corporate partner may compute an amount of foreign taxes deemed paid with respect to dividends received from a foreign corporation by a partnership or other pass-through entity. That issue will be the subject of a future proposed regulations project. However, in recognition of the holding in Revenue Ruling 71-141 (1971-1 C.B. 211) that a general partner of a domestic general partnership may compute an amount of foreign taxes deemed paid with respect to a dividend distribution from a foreign corporation to the partnership, section 1.902-1(a)(1) is amended to define a domestic shareholder as a domestic corporation that "owns" the requisite voting stock in a foreign corporation rather than one that "owns directly" the voting stock. The IRS is still considering under what other circumstances the revenue ruling should apply.

[16] Section 1.902-1(a)(8) is amended to clarify under what circumstances the pool of post-1986 foreign income taxes must be reduced to account for distributions made in prior post-1986 taxable years. The regulations require a reduction in the taxes pool for taxes attributable to earnings distributed to shareholders ineligible for the deemed paid credit (for example, a foreign shareholder, a U.S. individual shareholder, or a domestic corporate shareholder that owns less than 10 percent of the foreign corporation's voting stock) and to shareholders that are eligible for the credit but that choose to deduct foreign taxes under section 164(a) in the year of the distribution rather than claim a credit.

[17] The IRS understands that some taxpayers have taken the position, contrary to the position taken in section 1.902-1(a)(8) of the proposed regulations, that although post-1986 undistributed earnings must be reduced to account for all distributions out of current or accumulated earnings and profits, post-1986 foreign income taxes should be reduced only to account for taxes attributable to distributions with respect to which a shareholder both is eligible to claim a credit for foreign taxes deemed paid under section 902(a) and in fact elects to credit foreign taxes for the taxable year under section 901(a). These taxpayers argue that only in those circumstances are foreign taxes "deemed paid" and thus required to be removed from the taxes pool under a literal reading of sections 902(a) and 902(c)(2)(B).

[18] The IRS has not changed its position as reflected in section 1.902-1(a)(8)(i) of the proposed regulations that the foreign taxes pool must be reduced to account for foreign taxes attributable to all distributions and deemed distributions or inclusions to all shareholders. However, the text of the final regulations has been amended to clarify the rule. The requirement that the foreign taxes pool must be reduced proportionately as the earnings pool is reduced is consistent with the legislative history of the Tax Reform Act of 1986 (Public Law 99-514). The House Report states that under the pooling regime, "[a] dividend or subpart F inclusion is considered to bring with it a pro rata share of the accumulated foreign taxes paid by the subsidiary." H.R. Rep. No. 426, 99th Cong., 1st Sess. 357 (1985). In addition, removing taxes attributable to distributions to ineligible shareholders and eligible shareholders that choose to deduct foreign taxes is supported by the general matching principles of section 902, which presume that a dividend distribution will carry with it a ratable share of the foreign corporation's taxes. If taxes paid with respect to distributed earnings remained in the pool, eligible shareholders eventually could receive credits for more than their ratable share of the foreign corporation's taxes, a result at odds with the statutory scheme.

[19] Section 1.902-1(a)(8)(i) is amended to correct an oversight in the proposed regulation. In the case of a distribution out of current earnings and profits that is treated as a "nimble" dividend under section 316(a)(2) when there is a deficit in accumulated earnings and profits, post-1986 foreign income taxes are not reduced. This rule is not inconsistent with the general rule of paragraph (a)(8)(i) that the foreign taxes pool must be reduced to account for taxes attributable to all distributions and deemed distributions out of post-1986 undistributed earnings. Rather, it reflects the fact that under section 902 and these regulations, no taxes are deemed paid with respect to a nimble dividend under section 316(a)(2) because the post-1986 undistributed earnings pool is zero or less than zero.

[20] Section 1.902-1(a)(9), defining post-1986 undistributed earnings, is amended to clarify that the earnings pool is reduced only to account for distributions or deemed distributions that reduce earnings and profits and inclusions that result in previously-taxed amounts described in sections 959(c)(1) and (c)(2) or 1293(c). Thus, for example, in the case of a controlled foreign corporation owned 60 percent by a domestic corporate shareholder and 40 percent by a foreign shareholder, the earnings and taxes pools are reduced only to account for 60 percent of the foreign corporation's subpart F income.

[21] The rules precluding special allocations of earnings and taxes in section 1.902-1(a)(9)(iv) and (10)(ii) of the proposed regulations have been retained in the final regulations. These regulations are intended to reverse the result in Vulcan v. Commissioner, 96 T.C. 410 (1991), aff'd per curiam, 959 F.2d 973 (11th Cir. 1992), nonacq. 1995-1 C.B. 1, for post-1986 taxable years. Several commenters argued that the Vulcan decision was correct and should be applied to both pre-1987 and post-1986 taxable years, and the regulations should be revised to reflect the decision. For the reasons stated in the preamble to the proposed regulations, the IRS declines to do so.

[22] Commenters also argued that the rule precluding special allocations of earnings and taxes is inconsistent with section 1.904-6(a)(2). Section 1.904-6(a)(2) is an anti-abuse rule designed to prevent the use of accommodation parties to improve a United States taxpayer's foreign tax credit position. The rule states that if a taxpayer receives or accrues a dividend from a noncontrolled section 902 corporation and the Commissioner establishes the existence of an express or implied agreement that the dividend is paid out of the foreign corporation's passive or high withholding tax interest earnings, then only taxes imposed on passive or high withholding tax interest earnings will be considered related to the dividend. The IRS may invoke this rule to prevent a shareholder from sheltering investment income from tax by investing it through a noncontrolled section 902 corporation that distributes only the investment earnings to the shareholder, which then treats the distribution as a dividend sheltered by taxes paid on the corporation's high-taxed active business income. The IRS believes that this narrowly defined anti- abuse rule is an appropriate exception to the general rule of section 1.902-1(a)(9)(iv) and (a)(10)(ii) barring special allocations of earnings and taxes.

[23] Section 1.902-1(a)(11) has been amended to clarify that the definition of a dividend in section 316(a) applies for purposes of section 902, and that the section 902. Deemed inclusions under sections 951(a) and 1293 are not dividends for purposes of section 902 because they do not reduce the foreign corporation's earnings and profits. However, sections 960(a)(1) and 1293(f) provide that deemed paid taxes with respect to inclusions under sections 951(a) and 1293 are determined under section 902 in the same manner as if a dividend was paid.

[24] Paragraph (a)(11) also has been amended to add a cross- reference to section 1291 and section 1.1291-5 of the proposed regulations, which provide special rules for computing foreign taxes deemed paid with respect to distributions from section 1291 funds. These distributions are treated as dividends solely for foreign tax credit purposes, but the general section 902 computational rules do not apply.

[25] A commenter correctly pointed out that the regulation's inclusion of deemed distributions under section 551 as dividends for purposes of section 902 is contrary to the holding in Revenue Ruling 74-59 (1974-1 C.B. 183) that an amount includible in gross income under section 551 is not considered a dividend received for purposes of the allowance of a foreign tax credit under section 902. The holding of the revenue ruling is based on language in the 1937 legislative history of the foreign personal holding company provisions. The Report of the Joint Committee on Tax Evasion and Avoidance of the Congress of the United States, H.R. Doc. No. 337, 75th Cong., 1st Sess. 18 (1937), recommended that shareholders of foreign personal holding companies not be allowed a credit for foreign income taxes paid by the foreign corporation with respect to amounts deemed distributed. The Report goes on to state that the committee recommended against allowing a credit because "it is not administratively feasible, although it might seem equitable under the circumstances."

[26] Section 551(b) provides that amounts required to be included in the gross income of a U.S. shareholder under section 551(a) are treated as dividends, and under current law it is administratively feasible to allow deemed paid taxes to be computed with respect to deemed dividends. In addition, the Code now includes other anti-deferral regimes, e.g., the subpart F and passive foreign investment company provisions, the application of which may overlap with the foreign personal holding company rules. Shareholders are permitted to compute deemed paid taxes with respect to subpart F and passive foreign investment company inclusions.

[27] The IRS, therefore, has concluded the revenue ruling is not supported by current law. A shareholder of a foreign personal holding company should be entitled to compute deemed paid taxes with respect to amounts required to be included in gross income as dividends under section 551(a). Revenue Ruling 74-59 (1974-1 C.B. 183) is hereby revoked effective as of the date these regulations are published in the Federal Register.

[28] A commenter argued that the rule in section 1.902-1(b)(4), providing that no taxes are deemed paid with respect to dividends out of current earnings and profits when the foreign corporation has no post-1986 undistributed earnings and no accumulated earnings and profits (so-called "nimble" dividends) conflicts with the general purpose of the foreign tax credit to prevent double taxation. The rule is retained in the final regulations for two reasons. First, the legislative history of the Tax Reform Act of 1986 (Public Law 99-514) clearly indicates that Congress was aware of the issue and agreed with the position stated in the regulation. See S. Rep. No. 313, 99th Cong., 2d Sess. 321 (1986). Second, because no taxes can be deemed paid under the computational rules of section 902 when post-1986 undistributed earnings are zero or less than zero, no taxes are removed from the post-1986 foreign income taxes pool. Thus, all of the foreign corporation's taxes remain in its post-1986 foreign income taxes pool and are available to be credited if the corporation pays another dividend in a later year in which the post-1986 undistributed earnings pool is positive.

[29] Section 1.902-1(c)(8) of the proposed regulations reserved on the application of section 902 in section 304 exchanges. Commenters suggested that the regulations should address this area by incorporating the holdings in Revenue Ruling 91-5 (1991-1 C.B. 114), and Revenue Ruling 92-86 (1992-1 C.B. 199). In addition, the commenters argued that the regulations should state that a deemed paid credit is available in a section 304 exchange involving a foreign parent corporation. The IRS is still studying the area and the regulations thus continue to reserve on the application of section 902 in a section 304 exchange.

[30] Section 1.902-1(c)(9) of the proposed regulations is reserved in these final regulations. The proposed regulation provided a cross-reference to regulations under section 905(c) with respect to adjustments to post-1986 undistributed earnings and taxes that result from a section 482 allocation of income. There currently are no regulations under section 905(c) addressing section 482 allocations and the IRS, therefore, has reserved this paragraph pending issuance of final regulations under section 905(c).

[31] Section 1.902-1(d)(3)(ii) through (iv) of the proposed regulations is not included in the final regulations. Paragraph (d)(3) set out rules and examples exercising a grant of regulatory authority under the last sentence of section 904(d)(2)(E)(i) to limit beyond the statute the circumstances under which a dividend paid to a new U.S. shareholder by a controlled foreign corporation out of earnings accumulated while it was a controlled foreign corporation will be treated as dividends from a noncontrolled section 902 corporation. Identical rules were proposed in 1992 under section 904(d). See section 1.904-4(g)(3)(ii) through (iv) of the proposed regulations. The rules address the character of a dividend distribution under section 904(d) and are more appropriately placed in the regulations under that section. After considering the comments received, the rule will be finalized as part of the section 904 regulations.

Section 1.902-2

[32] A commenter suggested that the deficit carryback rules in section 1.902-2(a)(1) should be amended to provide that a deficit in post-1986 undistributed earnings will not be carried back to pre-1987 years on a return of capital or capital gain distribution. The rule states that a deficit will be carried back when "* * * a corporation makes a distribution to shareholders that is a dividend or would be a dividend if there were current or accumulated earnings and profits, * * *." The commenter suggests that the rule in the proposed regulation can result in "locked-in" taxes when earnings attributable to one or more pre-1987 years are eliminated by the deficit carryback. If the deficit stays in the post-1986 pool there is a chance it can be absorbed by future earnings, leaving the pre-1987 earnings and taxes intact. In support of its position, the commenter argues that section 902 establishes rules that minimize double taxation by allowing a taxpayer to compute a deemed paid credit on a taxable dividend. The legislative history indicates that the pooling provisions of section 902 are to apply solely for purposes of computing the deemed paid credit. Because a return of capital or capital gain distribution is not a taxable dividend and no section 902 credit is allowable, the commenter argues that the pooling rules (including the deficit carryback rules) should not apply.

[33] The IRS declines to adopt the commenter's suggestion. When an amount is distributed in a post-1986 taxable year and there is a deficit in post-1986 undistributed earnings, the deficit must be carried back and reduce earnings and profits in pre-1987 years to determine whether any earnings remain to support treatment of the distribution as a dividend. To the extent there are earnings remaining in one or more pre-1987 years after a deficit is carried back, the distribution is a dividend. Any remaining amount is a return of capital and capital gain. It would be incongruous to adopt a rule providing a different result if a single dollar of pre-1987 accumulated profits remains in a pre-1987 year after a post-1986 deficit is carried back than if the deficit carryback eliminated all pre-1987 accumulated profits and the entire distribution were treated as a return of capital.

[34] Another commenter argued that the interplay among section 1.902-2(b)(1) (pre-1987 accumulated deficit carries over to become the opening balance of post-1986 undistributed earnings pool) and section 1.902-1(b)(4) (no taxes deemed paid if a dividend is a nimble dividend) of the proposed regulations, and section 960 (incorporating the section 902 rules with respect to deemed inclusions under subpart F) results in a denial of deemed paid taxes to a U.S. shareholder if a controlled foreign corporation has both a pre-1987 accumulated deficit and post-1986 earnings and profits that are entirely subpart F income. The commenter suggests that regulations be issued under section 960 to provide, solely for purposes of that section, that accumulated deficits in pre-1987 accumulated profits will not carry over into the post-1986 pool.

[35] The IRS cannot adopt the rule the commenter suggests. Congress amended sections 902 and 960 in 1986 specifically to eliminate different earnings and profits and deemed paid taxes computations for purposes of sections 902 and 960. Further, in the situation the commenter posits, the credits are deferred but not permanently disallowed. If the controlled foreign corporation earns enough post-1986 income to eliminate the accumulated deficit, any distribution or deemed distribution will carry with it a ratable share of post-1986 foreign income taxes.

[36] A commenter argued that section 1.902-2(b)(2) and (3), Example 1, are incorrect because they imply that annual deficits in pre-1987 accumulated profits were required to be carried back under pre-1987 section 902 regardless of how foreign income taxes were determined. The commenter argues that pre-1987 section 902 requires a "correlation" between accumulated profits as determined under U.S. law and the foreign law method by which foreign taxes were determined.

[37] The IRS disagrees with the comment and the proposed regulation has not been amended. The regulation reflects the IRS' longstanding position that in the case of a deficit in accumulated profits of a foreign corporation for a particular pre-1987 year, the deficit first reduces prior years' accumulated profits on a LIFO basis to the extent thereof, and then the remaining deficit reduces accumulated profits in subsequent years. That rule applies regardless of whether foreign law permits or requires the carryback or carryforward of losses. See Revenue Ruling 74-550 (1974-2 C.B. 209) and Revenue Ruling 87-72 (1987-2 C.B. 170).

Effect on other documents

[38] The following revenue ruling is revoked as of January 7, 1997:

[39] Revenue Ruling 74-59, 1974-1 C.B. 183.

SPECIAL ANALYSES

[40] It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the notice of proposed rulemaking preceding the regulations was issued prior to March 29, 1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed rulemaking preceding these regulations was submitted to the Small Business Administration for comment on its impact on small business.

DRAFTING INFORMATION

[41] The principal author of these final regulations is Caren Silver Shein of the Office of Associate Chief Counsel (International), within the Office of Chief Counsel, IRS. However, other personnel from the IRS and Treasury Department participated in their development.

LIST OF SUBJECTS

26 CFR Part 1

[42] Income taxes, Reporting and -recordkeeping requirements.

26 CFR Part 602

[43] Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

[44] Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1 -- INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by adding entries in numerical order to read as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.902-1 also issued under 26 U.S.C. 902(c)(7).

Section 1.902-2 also issued under 26 U.S.C. 902(c)(7). * * *

Par. 2. Sections 1.902-1 and 1.902-2 are redesignated sections 1.902-3 and 1.902-4, respectively.

Par. 3. Sections 1.902-0, 1.902-1 and 1.902-2 are added to read as follows:

SECTION 1.902-0 OUTLINE OF REGULATIONS PROVISIONS FOR SECTION 902.

This section lists the provisions under section 902.

SECTION 1.902-1 CREDIT FOR DOMESTIC CORPORATE SHAREHOLDER OF A FOREIGN CORPORATION FOR FOREIGN INCOME TAXES PAID BY THE FOREIGN CORPORATION.

(a) Definitions and special effective date.

(1) Domestic shareholder.

(2) First-tier corporation.

(3) Second-tier corporation.

(4) Third-tier corporation.

(5) Example.

(6) Upper- and lower-tier corporations.

(7) Foreign income taxes.

(8) Post-1986 foreign income taxes.

(i) In general.

(ii) Distributions out of earnings and profits accumulated by a lower-tier corporation in its taxable years beginning before January 1, 1987, and included in the gross income of an upper-tier corporation in its taxable year beginning after December 31, 1986.

(iii) Foreign income taxes paid or accrued with respect to high withholding tax interest.

(9) Post-1986 undistributed earnings.

(i) In general.

(ii) Distributions out of earnings and profits accumulated by a lower-tier corporation in its taxable years beginning before January 1, 1987, and included in the gross income of an upper-tier corporation in its taxable year beginning after December 31, 1986.

(iii) Reduction for foreign income taxes paid or accrued.

(iv) Special allocations.

(10) Pre-1987 accumulated profits.

(i) Definition.

(ii) Computation of pre-1987 accumulated profits.

(iii) Foreign income taxes attributable to pre-1987 accumulated profits.

(11) Dividend.

(12) Dividend received.

(13) Special effective date.

(i) Rule.

(ii) Example.

(b) Computation of foreign income taxes deemed paid by a domestic shareholder, first-tier corporation, and second-tier corporation.

(1) General rule.

(2) Allocation rule for dividends attributable to post-1986 undistributed earnings and pre-1987 accumulated profits.

(i) Portion of dividend out of post-1986 undistributed earnings.

(ii) Portion of dividend out of pre-1987 accumulated profits.

(3) Dividends paid out of pre-1987 accumulated profits.

(4) Deficits in accumulated earnings and profits.

(5) Examples.

(c) Special rules.

(1) Separate computations required for dividends from each first-tier and lower-tier corporation.

(i) Rule.

(ii) Example.

(2) Section 78 gross-up.

(i) Foreign income taxes deemed paid by a domestic shareholder.

(ii) Foreign income taxes deemed paid by an upper-tier corporation.

(iii) Example.

(3) Creditable foreign income taxes.

(4) Foreign mineral income.

(5) Foreign taxes paid or accrued in connection with the purchase or sale of certain oil and gas.

(6) Foreign oil and gas extraction income.

(7) United States shareholders of controlled foreign corporations.

(8) Credit for foreign taxes deemed paid in a section 304 transaction.

(9) Effect of section 482 adjustments on post-1986 foreign income taxes and post-1986 undistributed earnings.

(d) Dividends from controlled foreign corporations.

(1) General rule.

(2) Look-through.

(i) Dividends.

(ii) Coordination with section 960.

(3) Dividends distributed out of earnings accumulated before a controlled foreign corporation became a controlled foreign corporation.

(i) General rule.

(ii) Dividend distributions out of earnings and profits for a year during which a shareholder that is currently a more-than-90-percent United States shareholder of a controlled foreign corporation was not a United States shareholder of the controlled foreign corporation.

(e) Information to be furnished.

(f) Examples.

(g) Effective date.

SECTION 1.902-2 TREATMENT OF DEFICITS IN POST-1986 UNDISTRIBUTED EARNINGS AND PRE-1987 ACCUMULATED PROFITS OF A FIRST-, SECOND-, OR THIRD-TIER CORPORATION FOR PURPOSES OF COMPUTING AN AMOUNT OF FOREIGN TAXES DEEMED PAID SECTION 1.902-1.

(a) Carryback of deficits in post-1986 undistributed earnings of a first-, second-, or third-tier corporation to pre-effective date taxable years.

(1) Rule.

(2) Examples.

(b) Carryforward of deficits in pre-1987 accumulated profits of a first-, second-, or third-tier corporation to post-1986 undistributed earnings for purposes of section 902.

(1) General rule.

(2) Effect of pre-effective date deficit.

(3) Examples.

SECTION 1.902-3 CREDIT FOR DOMESTIC CORPORATE SHAREHOLDER OF A FOREIGN CORPORATION FOR FOREIGN INCOME TAXES PAID WITH RESPECT TO ACCUMULATED PROFITS OF TAXABLE YEARS OF THE FOREIGN CORPORATION BEGINNING BEFORE JANUARY 1, 1987.

(a) Definitions.

(1) Domestic shareholder.

(2) First-tier corporation.

(3) Second-tier corporation.

(4) Third-tier corporation.

(5) Foreign income taxes.

(6) Dividend.

(7) Dividend received.

(b) Domestic shareholder owning stock in a first-tier corporation.

(1) In general.

(2) Amount of foreign taxes deemed paid by a domestic shareholder.

(c) First-tier corporation owning stock in a second-tier corporation.

(1) In general.

(2) Amount of foreign taxes deemed paid by a first-tier corporation.

(d) Second-tier corporation owning stock in a third-tier corporation.

(1) In general.

(2) Amount of foreign taxes deemed paid by a second-tier corporation.

(e) Determination of accumulated profits of a foreign corporation.

(f) Taxes paid on or with respect to accumulated profits of a foreign corporation.

(g) Determination of earnings and profits of a foreign corporation.

(1) Taxable year to which section 963 does not apply.

(2) Taxable year to which section 963 applies.

(3) Time and manner of making choice.

(4) Determination by district director.

(h) Source of income from first-tier corporation and country to which tax is deemed paid.

(1) Source of income.

(2) Country to which taxes deemed paid.

(i) United Kingdom income taxes paid with respect to royalties.

(j) Information to be furnished.

(k) Illustrations.

(l) Effective date.

SECTION 1.902-4 RULES FOR DISTRIBUTIONS ATTRIBUTABLE TO ACCUMULATED PROFITS FOR TAXABLE YEARS IN WHICH A FIRST-TIER CORPORATION WAS A LESS DEVELOPED COUNTRY CORPORATION.

(a) In general.

(b) Combined distributions.

(c) Distributions of a first-tier corporation attributable to certain distributions from second- or third-tier corporations.

(d) Illustrations.

SECTION 1.902-1 CREDIT FOR DOMESTIC CORPORATE SHAREHOLDER OF A FOREIGN CORPORATION FOR FOREIGN INCOME TAXES PAID BY THE FOREIGN CORPORATION.

(a) DEFINITIONS AND SPECIAL EFFECTIVE DATE. For purposes of section 902, this section, and section 1.902-2, the definitions provided in paragraphs (a)(1) through (12) of this section and the special effective date of paragraph (a)(13) of this section apply.

(1) DOMESTIC SHAREHOLDER. In the case of dividends received by a domestic corporation from a foreign corporation after December 31, 1986, the term domestic shareholder means a domestic corporation, other than an S corporation as defined in section 1361(a), that owns at least 10 percent of the voting stock of the foreign corporation at the time the domestic corporation receives a dividend from that foreign corporation.

(2) FIRST-TIER CORPORATION. In the case of dividends received by a domestic shareholder from a foreign corporation in a taxable year beginning after December 31, 1986, the term first-tier corporation means a foreign corporation, at least 10 percent of the voting stock of which is owned by a domestic shareholder at the time the domestic shareholder receives a dividend from that foreign corporation. The term first-tier corporation also includes a DISC or former DISC, but only with respect to dividends from the DISC or former DISC that are treated under sections 861(a)(2)(D) and 862(a)(2) as income from sources without the United States.

(3) SECOND-TIER CORPORATION. In the case of dividends paid to a first-tier corporation by a foreign corporation in a taxable year beginning after December 31, 1986, the foreign corporation is a second-tier corporation if, at the time a first-tier corporation receives a dividend from that foreign corporation, the first-tier corporation owns at least 10 percent of the foreign corporation's voting stock and the product of the following equals at least 5 percent --

(i) The percentage of voting stock owned by the domestic shareholder in the first-tier corporation; multiplied by

(ii) The percentage of voting stock owned by the first-tier corporation in the second-tier corporation.

(4) THIRD-TIER CORPORATION. In the case of dividends paid to a second-tier corporation by a foreign corporation in a taxable year beginning after December 31, 1986, a foreign corporation is a third- tier corporation if, at the time a second-tier corporation receives a dividend from that foreign corporation, the second-tier corporation owns at least 10 percent of the foreign corporation's voting stock and the product of the following equals at least 5 percent --

(i) The percentage of voting stock owned by the domestic shareholder in the first-tier corporation; multiplied by

(ii) The percentage of voting stock owned by the first-tier corporation in the second-tier corporation; multiplied by

(iii) The percentage of voting stock owned by the second-tier corporation in the third-tier corporation.

(5) EXAMPLE. The following example illustrates the ownership requirements of paragraphs (a)(1) through (4) of this section:

 EXAMPLE. (i) Domestic corporation M owns 30 percent of the

(7) FOREIGN INCOME TAXES. The term foreign income taxes means income, war profits, and excess profits taxes as defined in section 1.901-2(a), and taxes included in the term income, war profits, and excess profits taxes by reason of section 903, that are imposed by a foreign country or a possession of the United States, including any such taxes deemed paid by a foreign corporation under this section. Foreign income, war profits, and excess profits taxes shall not include amounts excluded from the definition of those taxes pursuant to section 901 and the regulations under that section. See also paragraphs (c)(4) and (5) of this section (concerning foreign taxes paid with respect to foreign mineral income and in connection with the purchase or sale of oil and gas).

(8) POST-1986 FOREIGN INCOME TAXES -- (i) IN GENERAL. Except as provided in paragraphs (a)(10) and (13) of this section, the term post-1986 foreign income taxes of a foreign corporation means the sum of the foreign income taxes paid, accrued, or deemed paid in the taxable year of the foreign corporation in which it distributes a dividend plus the foreign income taxes paid, accrued, or deemed paid in the foreign corporation's prior taxable years beginning after December 31, 1986, to the extent the foreign taxes were not paid or deemed paid by the foreign corporation on or with respect to earnings that in prior taxable years were distributed to, or otherwise included (e.g., under sections 304, 367(b), 551, 951(a), 1248 or 1293) in the income of, a foreign or domestic shareholder. Except as provided in paragraph (b)(4) of this section, foreign taxes paid or deemed paid by the foreign corporation on or with respect to earnings that were distributed or otherwise removed from post-1986 undistributed earnings in prior post-1986 taxable years shall be removed from post-1986 foreign income taxes regardless of whether the shareholder is eligible to compute an amount of foreign taxes deemed paid under section 902, and regardless of whether the shareholder in fact chose to credit foreign income taxes under section 901 for the year of the distribution or inclusion. Thus, if an amount is distributed or deemed distributed by a foreign corporation to a United States person that is not a domestic shareholder within the meaning of paragraph (a)(1) of this section (e.g., an individual or a corporation that owns less than 10% of the foreign corporation's voting stock), or to a foreign person that does not meet the definition of a first- or second-tier corporation under paragraph (a)(2) or (3) of this section, then although no foreign income taxes shall be deemed paid under section 902, foreign income taxes attributable to the distribution or deemed distribution that would have been deemed paid had the shareholder met the ownership requirements of paragraphs (a)(1) through (4) of this section shall be removed from post-1986 foreign income taxes. Further, if a domestic shareholder chooses to deduct foreign taxes paid or accrued for the taxable year of the distribution or inclusion, it shall nonetheless be deemed to have paid a proportionate share of the foreign corporation's post-1986 foreign income taxes under section 902(a), and the foreign taxes deemed paid must be removed from post- 1986 foreign income taxes. In the case of a foreign corporation the foreign income taxes of which are determined based on an accounting period of less than one year, the term year means that accounting period. See sections 441(b)(3) and 443.

(ii) DISTRIBUTIONS OUT OF EARNINGS AND PROFITS ACCUMULATED BY A LOWER-TIER CORPORATION IN ITS TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1987, AND INCLUDED IN THE GROSS INCOME OF AN UPPER-TIER CORPORATION IN ITS TAXABLE YEAR BEGINNING AFTER DECEMBER 31, 1986. Post-1986 foreign income taxes shall include foreign income taxes that are deemed paid by an upper-tier corporation with respect to distributions from a lower-tier corporation out of non-previously taxed pre-1987 accumulated profits, as defined in paragraph (a)(10) of this section, that are received by an upper-tier corporation in any taxable year of the upper-tier corporation beginning after December 31, 1986, provided the upper-tier corporation's earnings and profits in that year are included in its post-1986 undistributed earnings under paragraph (a)(9) of this section. Foreign income taxes deemed paid with respect to a distribution of pre-1987 accumulated profits shall be translated from the functional currency of the lower-tier corporation into dollars at the spot exchange rate in effect on the date of the distribution. To determine the character of the earnings and profits and associated taxes for foreign tax credit limitation purposes, see section 904 and section 1.904-7(a).

(iii) FOREIGN INCOME TAXES PAID OR ACCRUED WITH RESPECT TO HIGH WITHHOLDING TAX INTEREST. Post-1986 foreign income taxes shall not include foreign income taxes paid or accrued by a noncontrolled section 902 corporation (as defined in section 904(d)(2)(E)(i)) with respect to high withholding tax interest (as defined in section 904(d)(2)(B)) to the extent the foreign tax rate imposed on such interest exceeds 5 percent. See section 904(d)(2)(E)(ii) and section 1.904-4(g)(2)(iii). The reduction in foreign income taxes paid or accrued by the amount of tax in excess of 5 percent imposed on high withholding tax interest income must be computed in functional currency before foreign income taxes are translated into U.S. dollars and included in post-1986 foreign income taxes.

(9) POST-1986 UNDISTRIBUTED EARNINGS -- (i) IN GENERAL. Except as provided in paragraphs (a)(10) and (13) of this section, the term post-1986 undistributed earnings means the amount of the earnings and profits of a foreign corporation (computed in accordance with sections 964(a) and 986) accumulated in taxable years of the foreign corporation beginning after December 31, 1986, determined as of the close of the taxable year of the foreign corporation in which it distributes a dividend. Post-1986 undistributed earnings shall not be reduced by reason of any earnings distributed or otherwise included in income, for example under section 304, 367(b), 551, 951(a), 1248 or 1293, during the taxable year. Post-1986 undistributed earnings shall be reduced to account for distributions or deemed distributions that reduced earnings and profits and inclusions that resulted in previously-taxed amounts described in section 959(c)(1) and (2) or section 1293(c) in prior taxable years beginning after December 31, 1986. Thus, post-1986 undistributed earnings shall not be reduced to the extent of the ratable share of a controlled foreign corporation's subpart F income, as defined in section 952, attributable to a shareholder that is not a United States shareholder within the meaning of section 951(b) or section 953(c)(1)(A), because that amount has not been included in a shareholder's gross income. Post- 1986 undistributed earnings shall be reduced as provided herein regardless of whether any shareholder is deemed to have paid any foreign taxes, and regardless of whether any domestic shareholder chose to claim a foreign tax credit under section 901(a) for the year of the distribution. For rules on carrybacks and carryforwards of deficits and their effect on post-1986 undistributed earnings, see section 1.902-2. In the case of a foreign corporation the foreign income taxes of which are computed based on an accounting period of less than one year, the term year means that accounting period. See sections 441(b)(3) and 443.

(ii) DISTRIBUTIONS OUT OF EARNINGS AND PROFITS ACCUMULATED BY A LOWER-TIER CORPORATION IN ITS TAXABLE YEARS BEGINNING BEFORE JANUARY 1, 1987, AND INCLUDED IN THE GROSS INCOME OF AN UPPER-TIER CORPORATION IN ITS TAXABLE YEAR BEGINNING AFTER DECEMBER 31, 1986. Distributions by a lower-tier corporation out of non-previously taxed pre-1987 accumulated profits, as defined in paragraph (a)(10) of this section, that are received by an upper-tier corporation in any taxable year of the upper-tier corporation beginning after December 31, 1986, shall be treated as post-1986 undistributed earnings of the upper-tier corporation, provided the upper-tier corporation's earnings and profits for that year are included in its post-1986 undistributed earnings under paragraph (a)(9)(i) of this section. To determine the character of the earnings and profits and associated taxes for foreign tax credit limitation purposes, see section 904 and section 1.904-7(a).

(iii) REDUCTION FOR FOREIGN INCOME TAXES PAID OR ACCRUED. In computing post-1986 undistributed earnings, earnings and profits shall be reduced by foreign income taxes paid or accrued regardless of whether the taxes are creditable. Thus, earnings and profits shall be reduced by foreign income taxes paid with respect to high withholding tax interest even though a portion of the taxes is not creditable pursuant to section 904(d)(2)(E)(ii) and is not included in post-1986 foreign income taxes under paragraph (a)(8)(iii) of this section. Earnings and profits of an upper-tier corporation, however, shall not be reduced by foreign income taxes paid by a lower-tier corporation and deemed to have been paid by the upper-tier corporation.

(iv) SPECIAL ALLOCATIONS. The term post-1986 undistributed earnings means the total amount of the earnings of the corporation determined at the corporate level. Special allocations of earnings and taxes to particular shareholders, whether required or permitted by foreign law or a shareholder agreement, shall be disregarded. If, however, the Commissioner establishes that there is an agreement to pay dividends only out of earnings in the separate categories for passive or high withholding tax interest income, then only taxes imposed on passive or high withholding tax interest earnings shall be treated as related to the dividend. See section 1.904-6(a)(2).

(10) PRE-1987 ACCUMULATED PROFITS -- (i) DEFINITION. The term pre-1987 accumulated profits means the amount of the earnings and profits of a foreign corporation computed in accordance with section 902 and attributable to its taxable years beginning before January 1, 1987. If the special effective date of paragraph (a)(13) of this section applies, pre-1987 accumulated profits also includes any earnings and profits (computed in accordance with sections 964(a) and 986) attributable to the foreign corporation's taxable years beginning after December 31, 1986, but before the first day of the first taxable year of the foreign corporation in which the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are met with respect to that corporation.

(ii) COMPUTATION OF PRE-1987 ACCUMULATED PROFITS. Pre-1987 accumulated profits must be computed under United States principles governing the computation of earnings and profits. Pre-1987 accumulated profits are determined at the corporate level. Special allocations of accumulated profits and taxes to particular shareholders with respect to distributions of pre-1987 accumulated profits in taxable years beginning after December 31, 1986, whether required or permitted by foreign law or a shareholder agreement, shall be disregarded. Pre-1987 accumulated profits of a particular year shall be reduced by amounts distributed from those accumulated profits or otherwise included in income from those accumulated profits, for example under sections 304, 367(b), 551, 951(a), 1248 or 1293. If a deficit in post-1986 undistributed earnings is carried back to offset pre-1987 accumulated profits, pre-1987 accumulated profits of a particular taxable year shall be reduced by the amount of the deficit carried back to that year. See section 1.902-2. The amount of a distribution out of pre-1987 accumulated profits, and the amount of foreign income taxes deemed paid under section 902, shall be determined and translated into United States dollars by applying the law as in effect prior to the effective date of the Tax Reform Act of 1986. See sections 1.902-3, 1.902-4 and 1.964-1.

(iii) FOREIGN INCOME TAXES ATTRIBUTABLE TO PRE-1987 ACCUMULATED PROFITS. The term pre-1987 foreign income taxes means any foreign income taxes paid, accrued, or deemed paid by a foreign corporation on or with respect to its pre-1987 accumulated profits. Pre-1987 foreign income taxes of a particular year shall be reduced by the amount of taxes paid or deemed paid by the foreign corporation on or with respect to amounts distributed or otherwise included in income from pre-1987 accumulated profits of that year. Thus, pre-1987 foreign income taxes shall be reduced by the amount of taxes deemed paid by a domestic shareholder (regardless of whether the shareholder chose to credit foreign income taxes under section 901 for the year of the distribution or inclusion) or a first-tier or second-tier corporation, and by the amount of taxes that would have been deemed paid had any other shareholder been eligible to compute an amount of foreign taxes deemed paid under section 902. Foreign income taxes deemed paid with respect to a distribution of pre-1987 accumulated profits shall be translated from the functional currency of the distributing corporation into United States dollars at the spot exchange rate in effect on the date of the distribution.

(11) DIVIDEND. For purposes of section 902, the definition of the term dividend in section 316 and the regulations under that section applies. Thus, for example, distributions and deemed distributions under sections 302, 304, 305(b) and 367(b) that are treated as dividends within the meaning of section 301(c)(1) also are dividends for purposes of section 902. In addition, the term dividend includes deemed dividends under sections 551 and 1248, but not deemed inclusions under sections 951(a) and 1293. For rules concerning excess distributions from section 1291 funds that are treated as dividends solely for foreign tax credit purposes, (see Regulation Project INTL-656-87 published in 1992-1 C.B. 1124; see section 601.601(d)(2)(ii)(b) of this chapter).

(12) DIVIDEND RECEIVED. A dividend shall be considered received for purposes of section 902 when the cash or other property is unqualifiedly made subject to the demands of the distributee. See section 1.301-1(b). A dividend also is considered received for purposes of section 902 when it is deemed received under section 304, 367(b), 551, or 1248.

(13) SPECIAL EFFECTIVE DATE -- (i) RULE. If the first day on which the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are met with respect to a foreign corporation, without regard to whether a dividend is distributed, is in a taxable year of the foreign corporation beginning after December 31, 1986, then --

(A) The post-1986 undistributed earnings and post-1986 foreign income taxes of the foreign corporation shall be determined by taking into account only taxable years beginning on and after the first day of the first taxable year of the foreign corporation in which the ownership requirements are met, including subsequent table years in which the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are not met; and

(B) Earnings and profits accumulated prior to the first day of the first taxable year of the foreign corporation in which the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are met shall be considered pre-1987 accumulated profits.

(ii) EXAMPLE. The following example illustrates the special effective date rules of this paragraph (a)(13):

EXAMPLE. As of December 31, 1991, and since its incorporation, foreign corporation A has owned 100 percent of the stock of foreign corporation B. Corporation B is not a controlled foreign corporation. Corporation B uses the calendar year as its taxable year, and its functional currency is the u. Assume 1u equals $1 at all relevant times. On April 1, 1992, Corporation B pays a 200u dividend to Corporation A and the ownership requirements of section 902(c)(3)(B) and paragraphs (a)(1) through (4) of this section are not met at that time. On July 1, 1992, domestic corporation M purchases 10 percent of the Corporation B stock from Corporation A and, for the first time, Corporation B meets the ownership requirements of section 902(c)(3)(B) and paragraph (a)(2) of this section. Corporation M uses the calendar year as its taxable year. Corporation B does not distribute any dividends to Corporation M during 1992. For its taxable year ending December 31, 1992, Corporation B has 500u of earnings and profits (after foreign taxes but before taking into account the 200u distribution to Corporation A) and pays 100u of foreign income taxes that is equal to $100. Pursuant to paragraph (a)(13)(i) of this section, Corporation B's post-1986 undistributed earnings and post-1986 foreign income taxes will include earnings and profits and foreign income taxes attributable to Corporation B's entire 1992 taxable year and all taxable years thereafter. Thus, the April 1, 1992, dividend to Corporation A will reduce post-1986 undistributed earnings to 300u (500u - 200u) under paragraph (a)(9)(i) of this section. The foreign income taxes attributable to the amount distributed as a dividend to Corporation A will not be creditable because Corporation A is not a domestic shareholder. Post-1986 foreign income taxes, however, will be reduced by the amount of foreign taxes attributable to the dividend. Thus, as of the beginning of 1993, Corporation B has $60 ($100 - [$100 x 40% (200u/500u)]) of post-1986 foreign income taxes. See paragraphs (a)(8)(i) and (b)(1) of this section.

(b) COMPUTATION OF FOREIGN INCOME TAXES DEEMED PAID BY A DOMESTIC SHAREHOLDER, FIRST-TIER CORPORATION, AND SECOND-TIER CORPORATION -- (1) GENERAL RULE. If a foreign corporation pays a dividend in any taxable year out of post-1986 undistributed earnings to a shareholder that is a domestic shareholder or an upper-tier corporation at the time it receives the dividend, the recipient shall be deemed to have paid the same proportion of any post-1986 foreign income taxes paid, accrued or deemed paid by the distributing corporation on or with respect to post-1986 undistributed earnings which the amount of the dividend out of post-1986 undistributed earnings (determined without regard to the gross-up under section 78) bears to the amount of the distributing corporation's post-1986 undistributed earnings. An upper-tier corporation shall not be entitled to compute an amount of foreign taxes deemed paid on a dividend from a lower-tier corporation, however, unless the ownership requirements of paragraphs (a)(1) through (4) of this section are met at each tier at the time the upper-tier corporation receives the dividend. Foreign income taxes deemed paid by a domestic shareholder or an upper-tier corporation must be computed under the following formula:

                                       Dividend paid to

 Portion of

 Portion of            Dividend Paid

(4) DEFICITS IN ACCUMULATED EARNINGS AND PROFITS. No foreign income taxes shall be deemed paid with respect to a distribution from a foreign corporation out of current earnings and profits that is treated as a dividend under section 316(a)(2), and post-1986 foreign income taxes shall not be reduced, if as of the end of the taxable year in which the dividend is paid or accrued, the corporation has zero or a deficit in post-1986 undistributed earnings and the sum of current plus accumulated earnings and profits is zero or less than zero. The dividend shall reduce post-1986 undistributed earnings and accumulated earnings and profits.

(5) EXAMPLES. The following examples illustrate the rules of this paragraph (b):

 EXAMPLE 1. Domestic corporation M owns 100 percent of

(ii) EXAMPLE. The following example illustrates the application of this paragraph (c)(1):

EXAMPLE. P, a domestic corporation, owns 40 percent of the voting stock of foreign corporation S. S owns 30 percent of the voting stock of foreign corporation T, and 30 percent of the voting stock of foreign corporation U. Neither S, T, nor U is a controlled foreign corporation. P, S, T and U all use the calendar year as their taxable year. In 1993, T and U both pay dividends to S and S pays a dividend to P. To compute foreign taxes deemed paid, paragraph (c)(1) of this section requires P to start with the lowest tier corporations and to compute foreign taxes deemed paid separately for dividends from each first-tier and lower-tier corporation. Thus, S first will compute foreign taxes deemed paid separately on its dividends from T and U. The deemed paid taxes will be added to S's post- 1986 foreign income taxes, and the dividends will be added to S's post-1986 undistributed earnings. Next, P will compute foreign taxes deemed paid with respect to the dividend from S. This computation will take into account the taxes paid by T and U and deemed paid by S.

(2) SECTION 78 GROSS-UP -- (i) FOREIGN INCOME TAXES DEEMED PAID BY A DOMESTIC SHAREHOLDER. Except as provided in section 960(b) and the regulations under that section (relating to amounts excluded from gross income under section 959(b)), any foreign income taxes deemed paid by a domestic shareholder in any taxable year under section 902(a) and paragraph (b) of this section shall be included in the gross income of the domestic shareholder for the year as a dividend under section 78. Amounts included in gross income under section 78 shall, for purposes of section 904, be deemed to be derived from sources within the United States to the extent the earnings and profits on which the taxes were paid are treated under section 904(g) as United States source earnings and profits. Section 1.904-5(m)(6). Amounts included in gross income under section 78 shall be treated for purposes of section 904 as income in a separate category to the extent that the foreign income taxes were allocated and apportioned to income in that separate category. See section 904(d)(3)(G) and section 1.904-6(b)(3).

(ii) FOURTEEN INCOME TAXES DEEMED PAID BY AN UPPER-TIER CORPORATION. Foreign income taxes deemed paid by an upper-tier corporation on a distribution from a lower-tier corporation are not included in the earnings and profits of the upper-tier corporation. For purposes of section 904, foreign income taxes shall be allocated and apportioned to income in a separate category to the extent those taxes were allocated to the earnings and profits of the lower-tier corporation in that separate category. See section 904(d)(3)(G) and section 1.904-6(b)(3). To the extent that section 904(g) treats the earnings of the lower-tier corporation on which those foreign income taxes were paid as United States source earnings and profits, the foreign income taxes deemed paid by the upper-tier corporation on the distribution from the lower-tier corporation shall be treated as attributable to United States source earnings and profits. See section 904(g) and section 1.904-5(m)(6).

(iii) EXAMPLE. The following example illustrates the rules of this paragraph (c)(2):

 EXAMPLE. P, a domestic corporation, owns 100 percent of the

(4) FOREIGN MINERAL INCOME. Certain foreign income, war profits and excess profits taxes paid or accrued with respect to foreign mineral income will not be considered foreign income taxes for purposes of section 902. See section 901(e) and section 1.901-3.

(5) FOREIGN TAXES PAID OR ACCRUED IN CONNECTION WITH THE PURCHASE OR SALE OF CERTAIN OIL AND GAS. Certain income, war profits, or excess profits taxes paid or accrued to a foreign country in connection with the purchase and sale of oil or gas extracted in that country will not be considered foreign income taxes for purposes of section 902. See section 901(f).

(6) FOREIGN OIL AND GAS EXTRACTION INCOME. For rules relating to reduction of the amount of foreign income taxes deemed paid with respect to foreign oil and gas extraction income, see section 907(a) and the regulations under that section.

(7) UNITED STATES SHAREHOLDERS OF CONTROLLED FOREIGN CORPORATIONS. See paragraph (d) of this section and sections 960 and 962 and the regulations under those sections for special rules relating to the application of section 902 in computing foreign income taxes deemed paid by United States shareholders of controlled foreign corporations.

(8) CREDIT FOR FOREIGN TAXES DEEMED PAID IN A SECTION 304 TRANSACTION. [Reserved].

(9) EFFECT OF SECTION 482 ADJUSTMENTS ON POST-1986 FOREIGN INCOME TAXES AND POST-1986 UNDISTRIBUTED EARNINGS. [Reserved].

(d) DIVIDENDS FROM CONTROLLED FOREIGN CORPORATIONS -- (1) GENERAL RULE. Except as provided in paragraph (d)(3) of this section, if a dividend is received by a domestic shareholder that is a United States shareholder (as defined in section 951(b) or section 953(c)(1)(A)) from a first-tier corporation that is a controlled foreign corporation (as defined in section 957(a) or section 953 (c)(1)(B)), or by an upper-tier corporation from a lower-tier corporation if the corporations are related look-through entities within the meaning of section 1.904-5(i), the following rule applies. If a dividend is paid out of post-1986 undistributed earnings or pre- 1987 accumulated profits of the upper- or lower-tier controlled foreign corporation attributable to more than one separate category under section 904(d), the amount of foreign income taxes deemed paid by the domestic shareholder or the upper-tier corporation under section 902 and paragraph (b) of this section shall be computed separately with respect to the post-1986 undistributed earnings or pre-1987 accumulated profits in each separate category out of which the dividend is paid. See section 1.904-5(c)(4) and paragraph (d)(2) of this section. The separately computed deemed paid taxes shall be added to other taxes paid by the U.S. shareholder or upper-tier corporation with respect to income in the appropriate separate category.

(2) LOOK-THROUGH -- (i) DIVIDENDS. Except as otherwise provided in paragraph (d)(3) of this section, any dividend distribution out of post-1986 undistributed earnings of a look-through entity to a related look-through entity shall be deemed to be paid pro rata out of each separate category of income. See sections 1.904-5(c)(4) and 1.904-7. The portion of the foreign income taxes attributable to a particular separate category that shall be deemed paid by the domestic shareholder or upper-tier corporation must be computed under the following formula:

 Foreign taxes     Post-1986       Dividend amount

(3) DIVIDENDS DISTRIBUTED OUT OF EARNINGS ACCUMULATED BEFORE A CONTROLLED FOREIGN CORPORATION BECAME A CONTROLLED FOREIGN CORPORATION -- (i) GENERAL RULE. Any dividend distributed by a controlled foreign corporation out of earnings accumulated before the controlled foreign corporation became a controlled foreign corporation shall be treated as a dividend from a noncontrolled section 902 corporation regardless of whether the earnings were accumulated in a taxable year beginning before January 1, 1987, or after December 31, 1986.

(ii) DIVIDEND DISTRIBUTIONS OUT OF EARNINGS AND PROFITS FOR A YEAR DURING WHICH A SHAREHOLDER THAT IS CURRENTLY A MORE-THAN-90-PERCENT UNITED STATES SHAREHOLDER OF A CONTROLLED FOREIGN CORPORATION WAS NOT A UNITED STATES SHAREHOLDER OF THE CONTROLLED FOREIGN CORPORATION. [Reserved].

(e) INFORMATION TO BE FURNISHED. If the credit for foreign income taxes claimed under section 901 includes foreign income taxes deemed paid under section 902 and paragraph (b) of this section, the domestic shareholder must furnish the same information with respect to the foreign income taxes deemed paid as it is required to furnish with respect to the foreign income taxes it directly paid or accrued and for which the credit is claimed. See section 1.905-2. For other information required to be furnished by the domestic shareholder for the annual accounting period of certain foreign corporations ending with or within the shareholder's taxable year, and for reduction in the amount of foreign income taxes paid, accrued, or deemed paid for failure to furnish the required information, see section 6038 and the regulations under that section.

(f) EXAMPLES. The following examples illustrate the application of this section:

 Example 1. Since 1987, domestic corporation M has owned 10

SECTION 1.902-2 TREATMENT OF DEFICITS IN POST-1986 UNDISTRIBUTED EARNINGS AND PRE-1987 ACCUMULATED PROFITS OF A FIRST-, SECOND-, OR THIRD-TIER CORPORATION FOR PURPOSES OF COMPUTING AN AMOUNT OF FOREIGN TAXES DEEMED PAID UNDER SECTION 1.902-1.

(a) CARRYBACK OF DEFICITS IN POST-1986 UNDISTRIBUTED EARNINGS OF A FIRST-, SECOND-, OR THIRD-TIER CORPORATION TO PRE-EFFECTIVE DATE TAXABLE YEARS -- (1) RULE. For purposes of computing foreign income taxes deemed paid under section 1.902-1(b) with respect to dividends paid by a first-, second-, or third-tier corporation, when there is a deficit in the post-1986 undistributed earnings of that corporation and the corporation makes a distribution to shareholders that is a dividend or would be a dividend if there were current or accumulated earnings and profits, then the post-1986 deficit shall be carried back to the most recent pre-effective date taxable year of the first-, second-, or third-tier corporation with positive accumulated profits computed under section 902. See section 1.902-3(e). For purposes of this section 1.902-2, a pre-effective date taxable year is a taxable year beginning before January 1, 1987, or a taxable year beginning after December 31, 1986, if the special effective date of section 1.902-1(a)(13) applies. The deficit shall reduce the section 902 accumulated profits in the most recent pre-effective date year to the extent thereof, and any remaining deficit shall be carried back to the next preceding year or years until the deficit is completely allocated. The amount carried back shall reduce the deficit in post-1986 undistributed earnings. Any foreign income taxes paid in a post-effective date year will not be carried back to pre- effective date taxable years or removed from post-1986 foreign income taxes. See section 960 and the regulations under that section for rules governing the carryback of deficits and the computation of foreign income taxes deemed paid with respect to deemed income inclusions from controlled foreign corporations.

(2) EXAMPLES. The following examples illustrate the rules of this paragraph (a):

 EXAMPLE 1. (i) From 1985 through 1990, domestic corporation

(2) EFFECT OF PRE-EFFECTIVE DATE DEFICIT. If a foreign corporation has a deficit in accumulated profits as of the end of its last pre-effective date taxable year, then the foreign corporation cannot pay a dividend out of pre-effective date years unless there is an adjustment made (for example, a refund of foreign taxes paid) that restores section 902 accumulated profits to a pre-effective date taxable year or years. Moreover, if a foreign corporation has a deficit in section 902 accumulated profits as of the end of its last pre-effective date taxable year, then no deficit in post-1986 undistributed earnings will be carried back under paragraph (a) of this section. For rules concerning carrybacks of eligible deficits from post-1986 undistributed earnings to reduce pre-1987 earnings and profits computed under section 964(a), see section 960 and the regulations under that section.

(3) EXAMPLES. The following examples illustrate the rules of this paragraph (b):

 EXAMPLE 1. (i) From 1984 through 1988, domestic corporation

SECTION 1.902-3 CREDIT FOR DOMESTIC CORPORATE SHAREHOLDER OF A FOREIGN CORPORATION FOR FOREIGN INCOME TAXES PAID WITH RESPECT TO ACCUMULATED PROFITS OF TAXABLE YEARS OF THE FOREIGN CORPORATION BEGINNING BEFORE JANUARY 1, 1987.

(a) DEFINITIONS. For purposes of section 902 and sections 1.902-3 and 1.902-4:

* * * * *

(l) EFFECTIVE DATE. Except as provided in section 1.902-4, this section applies to any distribution received from a first-tier corporation by its domestic shareholder after December 31, 1964, and before the beginning of the foreign corporation's first taxable year beginning after December 31, 1986. If, however, the first day on which the ownership requirements of section 902(c)(3)(B) and section 1.902-1(a)(1) through (4) are met with respect to the foreign corporation is in a taxable year of the foreign corporation beginning after December 31, 1986, then this section shall apply to all taxable years beginning after December 31, 1964, and before the year in which the ownership requirements are first met. See section 1.902-1(a)(13)(iii). For corresponding rules applicable to distributions received by the domestic shareholder prior to January 1, 1965, see section 1.902-5 as contained in the 26 CFR part 1 edition revised April 1, 1976.

Par. 5. Newly designated section 1.902-4, paragraph (b), in the last sentence, the language "section 1.902-1" is removed and "section 1.902-3" is added in its place.

PART 602 -- OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 6. The authority citation for part 602 continues to read as follows:

Authority: 26 U.S.C. 7805.

Par. 7. In section 602.101, paragraph (c) is amended by adding an entry in numerical order to the table to read as follows:

SECTION 602.101 OMB CONTROL NUMBERS.

* * * * *

(c) * * *

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